I-2.2: Regulation and Neutrality: The Case of Financial Markets

At first glance, associating the terms regulation and neutrality seems to be an oxymoron, to cite Marie-Anne Frison-Roche’s expression*.

Before beginning on my subject, I would like to state that I understand the term regulation in a broad sense, beyond simple rulemaking. It refers to the ensemble of schemes, rules, good practices, and information systems necessary for the surveillance and oversight of complex systems. Therefore, my thoughts are not related to a particular institutional context more or less related to the State, but rather, to a function that can be carried out in different ways.

I would also like to distinguish between neutrality and impartiality, which are similar, but different, notions. Indeed, I understand neutrality as an objective and functional characteristic, whereas impartiality is a type of behavior.

Lastly, I believe that neutrality should be evaluated in relation to a concrete example, such as whether indirect taxation can be consumption-neutral: such taxes are not neutral because they influence individual choices and affect the saving-consumption ratio. On the other hand, a cascading tax is not neutral, because it affects the entire system of production and distribution, whereas Value Added Tax (VAT) is production-and-distribution-neutral.

Concerning market regulation, I believe that:

• market regulation is, in essence, not neutral
• market regulation aims for neutrality in its implementation
• regulation’s operational neutrality is harmed by market fragmentation and competition between financial markets

1. Financial regulation is not neutral

Indeed, financial regulation attempts to prevent, correct, or sanction acts, processes, and behaviors seen as contrary to the political objectives determined by reference to basic principles, which it is believed cannot be achieved by market actors’ spontaneous game.

In doing this, regulation enforces constraints inspired by society’s choices, as shown by the goals and principles set forth by the International Organization of Securities Commissions, which inspired many of the provisions contained in the European Union’s Financial Services Action Plan.

These goals belie a will to intervene in order to protect investors, ensure financial markets function smoothly, and promote financial stability. There is no room here for neutrality.

Investor protection is opposed to the neutrality of the principle of “caveat emptor,” and regulation precisely aims at correcting the “asymmetries of information” that affect the relationship between those in the know and others. This is the logic behind the European Union’s “prospectus” and “transparency” directives that aim at reducing business secrecy by requiring issuers of financial instruments to make public, as soon as possible, any information that, if it were known to the general public, would be likely to have an influence on the price of their stock.

This political choice is not neutral: it clearly takes investors’ side and has a direct impact on agents’ behavior. Consequently, some companies might cancel their plans to become publicly traded in order not to have to deal with these obligations.

The absence of neutrality is also palpable when rules modify the relationship between the strong and the weak, such as the rules concerning the protection of minority shareholders in restructuring operations concerning publicly traded companies (such as the rules concerning tender offers and delisting).

In the same spirit, certain rules modulate intermediaries’ obligations concerning client relationships by limiting their possibilities for marketing complex products, or by imposing specific advisory obligations (such as “know your client”).

Making sure the market functions smoothly means the regulator has to intervene in the organization of transactional and post-market infrastructures, such as clearinghouses, settlement and delivery systems, and depositories.

It directly influences competition: during the debates over restructuring that took place between Paris, London, and Frankfurt in the early 2000s, the British Competition Regulator criticized the Deutsche Börse’s centralized operation with market and post-market operations being carried out within the same ensemble.

Similarly, the regulator has a hand in defining the types of orders and the permissible exceptions to the ordinary rule of a central order book, especially whether or not to allow block negotiation at prices different from those practiced on the market, or whether or not to accept a certain amount of opacity for massive orders (known as dark pools).

Finally, the regulator directly influences agents’ behavior and imposes discipline on them, by using sanctions when necessary (cf. the market abuse directive).

The pursuit of financial stability has justified many interventions that profoundly influence markets and behavior.

Thereby, the prudential rules that govern capital or liquidity requirements in function of each profession or product are determining for corporate organization and strategy.

Similarly, the regulator can considerably influence the way the market functions by authorizing short selling or re-use, or by subjecting them to conditions.

2. Regulation can and should be implemented neutrally. Rules must apply to all in the same way. However, enforcement of the rules may require varying degrees of severity.

Regulation should be neutral with regards to agents’ choices:

It should not influence their size, subject to competition rules (and yet, the crisis has led us to consider the issue of ‘too big to fail’).

It should not influence their business model (specialization or multidisciplinary), subject to the limits imposed by conflict of interest rules (cf. the debates in the USA relating to the Dodd-Frank Act and the Volcker Rule).

It should not affect their choice of legal personality, amongst the choices available to them: Corporation, Mutual, or Cooperative; publicly traded or privately held, etc.

Regulation should not influence strategy in any given regulatory framework: the choice of target clientele, the choice of products, the choice of method of distribution, etc.

Regulation should not interfere, whatever the rules enforced, with investors’ choices and should respect their liberty and their liability: to invest in the long or the short term, to diversify their portfolios or not, etc…

Finally, regulation should be implemented with neutrality and impartiality when pursuits and sanctions are engaged. This is why there are recurrent debates over whether the ‘big’ are treated differently than the ‘small’, or the powerful than the weak.

3. The pursuit of operational neutrality within a given regulatory framework can be harmed by competition between financial markets.

The fragmentation of markets and regulations engenders regulatory forum shopping and creates potential competition between regulators, which is revelatory of the absence of neutrality in regulation.

The creation of the euro-dollar market in London is an example of this.

Closer to home, the back-and-forth of transaction volumes between London and Paris in the early 90s was due to different treatment in block negotiations, which led the French regulator to adopt the British position.

Similarly, the application of the Loi Toubon to mandatory prospectuses for shares traded in France was fatal to trading in Paris until a happy exception restored the balance. Finally, we could evoke the bitterness of the European debate on regulating hedge funds, which might cause a change in the place these funds (and their managers) set up their headquarters.

Within Europe, varying interpretations and actual implementations of identical rules can cause distortions that influence behavior and business.

This phenomenon particularly impacted investment management and investment strategies for collective investments.

To conclude, we must recognize that regulation, far from being neutral, fundamentally plays a structuring role.

That is not to say that we should forget neutrality, nor should we abandon impartiality in implementing regulation. In a context of regional (the Single European Market) and global integration, schemes to harmonize standards and rules must be reinforced, as well as the construction of a more integrated supervisory structure.

This is the ambitious yet unavoidable task that the bodies in charge of this process must accomplish, under the supervision of the G20 and the Financial Stability Council on a global level, and of the European Union on the European level. 

* See Frison-Roche, Marie-Anne, What is to act neutrally in regulated sectors ? Forthcoming in The Journal of Regulation.